The Payoff for Low Cost Index Investing

May 22, 2009

Article By: Scott Burns

Ten years ago Fidelity Magellan fund was riding high. Topping $100 billion in assets under management, it was the largest fund in the industry. Indeed, Magellan was larger than many entire mutual fund firms. The fund generated more than $600 million in fees for Fidelity Investments.

As you might expect, the continued success of the fund was a matter of the highest importance for Fidelity as a firm--- Magellan was the mother lode. As a firm, Fidelity was also an incredible brain trust. The best and the brightest already worked at Fidelity. It had the resources to hire anyone it chose, if that was deemed the best decision.

With so much at stake, so much talent and such abundant resources, you would think that Magellan fund would easily have remained a top-performing fund.

But it didn’t.

Today, according to Morningstar data, Magellan is a slender shadow of its past. It now has only $17 billion under management. It ranks 29th in size, 44th if you include money market funds. More important, over the last 10 years, 62 percent of its competitors have provided higher returns. Over the last 12 months, 3 years and 5 years, it has ranked below 95 percent, 89 percent, and 88 percent, respectively, of its large growth fund competition, according to Morningstar data. As a consequence, today it brings in about $500 million a year less in fees than it did 10 years ago.

I tell you this for a reason. If Fidelity, with all its savvy and resources, can’t pick a winning manager, just what do you think the chances are of you or me doing it? What do you think are the chances that the average investment adviser can do it?

In fact, the odds are poor, whoever does it.

Worse, picking a fund manager isn’t a once-in-a-lifetime decision. It’s a decision that has to be made again and again. Fund managers, on average, don’t stay at the same fund very long. According to the Morningstar database, for instance, the average duration of all fund managers at a particular fund is only 4.5 years. Restrict your sample to the largest funds--- those with at least $1 billion under management--- and the average tenure rises to 6.6 years.

This means a 30-year-old worker will need to make a fund decision 6 times before retirement and another 3 times after retirement. Each time he makes that decision--- or pays a professional to make the decision---the probability of doing better than an index fund is about 30 percent.

Those aren’t very good odds.

In fact, the odds are dismal. The probability of making two good decisions in a row is only 9 percent. Try to make three good decisions in a row and the probability of success is only 2.7 percent. By the fourth decision, the probability of making a winning choice each time is less than 1 percent.

Meanwhile, the fee meters are running, transferring billions of dollars from the return on our investments to the financial services industry. This happens year in and year out. The financial services fee machine does incredible damage to retirement security.

Fortunately, there are signs that we’re beginning to understand this is a no-win game. Today, 8 of the 28 funds that are larger than Magellan are index funds. Money follows performance--- and low-expense index funds routinely trump the expensive pride of our fee-bloated financial services industry.

During 2008, balanced funds--- an asset allocation that is close to the holdings of the average 401(k) plan investor--- lost a stunning 28 percent of their value. It was one of the worst declines in history. If you calculate the cost of additional expenses, however, you’ll find that a 30-year-old worker in a 401(k) plan with average expenses of 1.25 percent will lose 22.4 percent of what he might have accumulated in the low-cost index fund-based federal Thrift Savings Plan.

In a more expensive plan that cost an average of 2 percent a year (as many insurance-based 403(b) plans do), the same worker would lose a whopping 33 percent of his potential accumulation.

The Long-Term Cost of High Expense Investing

This table compares the 37-year accumulation of a 30-year-old worker who saves 10 percent of income each year, receives a 5 percent annual raise and works during a period when inflation averages 4 percent. He also invests in a 60/40 mixture of domestic stocks and long-term government bonds to achieve a pre-expense annualized return of 8.72 percent. The greater the annual expenses paid, the greater the long-term reduction in retirement resources.

This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.